The US infrastructure market is in a state of flux. With both pension funds and private equity firms showing serious interest in infrastructure assets, a rash of new US infrastructure funds have sprung up. As a consequence, billions of dollars are now being bestowed upon the sector, and many new projects are in the works. This is changing how infrastructure assets are financed, how deals are structured and the pricing of infrastructure assets.

Over the past 24 months, more than $500 billion of leveraged infrastructure purchasing power has been injected into the US infrastructure space, says Rob Collins, executive director and head of infrastructure M&A at Morgan Stanley. "This has been driven by pension funds and private equity firms that are looking to invest in secure assets with municipal characteristics, which is difficult to find outside this type of asset class," he says.

The desire for longer-term, stable assets comes on the back of a changing regulatory environment and investment climate. John Minderides, managing director and global head of transition management at JP Morgan says: "Pension funds are facing increasing scrutiny on their activities, and there is growing pressure to look at issues such as solvency and accounting changes. Many funds are restructuring assets to deal with this."

Institutions such as pension funds with long-term liabilities are looking at ways to better match their assets and liabilities, adds Geoffrey Spence, global head of infrastructure finance in project and export finance at HSBC. "In many respects the biggest thing they have to deliver right now is protection against inflation, so there is a demand for long-term inflation-linked funding."

In the past this demand was met with inflation-linked government bonds. "But now they are realizing that with infrastructure assets they are getting the long-term assets with higher returns than the government bonds provide, although clearly not the same returns as traditional private equity deals would offer," Spence adds. Indeed, infrastructure assets provide long-term stable cashflows with relatively high margins and low risk.

PE taking lessons

Jorge Rodriguez, head of the US infrastructure team at Dresdner Kleinwort, says the traditional investors in this space – for example Canadian funds such as Borealis and Ontario Teachers, and Australian funds such as those run by Macquarie and Babcock & Brown – have a different investment philosophy than the traditional private equity firms that are now looking at infrastructure, such as the Carlyle Group. "These private equity firms traditionally look for an IRR [internal rate of return] of 25% or higher and exit after just a few years, but infrastructure funds have very different characteristics," he says. "They are long-term investors by nature and typically have an IRR in the mid-teens." Of those PE firms that are getting into infrastructure, most are raising separate funds – offered alongside their traditional high-margin, quick exit funds.

"This business really originated in Australia and Europe, and it was international players that started to identify this as an opportunity in the US," says Rodriguez. "Since then it has really taken off." Although much of the initial interest in US infrastructure deals came from international investors and project financiers, the flood of interest has also spread to US funds and private equity firms, keen to take advantage of the stable characteristics and decent returns offered by infrastructure assets.

Collins says: "While we are seeing more and more infrastructure funds emerge, we are also seeing pension funds looking to invest in state assets in their own state – effectively purchasing assets directly." This movement echoes the initial interest from Australian and Canadian funds, which were among the earliest investors in their states' private infrastructure deals. Sources following the market say that such involvement may help to neutralize some local opposition to assets sales, as exemplified by the reaction to the sale of the Indiana Toll Road to Spanish (Cintra) and Australian (Macquarie) bidders.

Increasing demand for infrastructure assets is usually presented as helpful to state and local governments as it allows them to unlock equity in those assets that they are unable to on their own. Such assets in the US were traditionally funded largely through state governments – and their construction was the domain of government agencies that raise funds in the municipal finance market. But many state agencies are now constrained in their ability to raise funds, and so are looking to the private sector – through PPPs, privatizing assets or selling concessions.

Collins says: "Municipalities are increasingly launching strategic advisory engagements, and are really seeing private-sector financing as a valid technique to solve funding gaps." The most recent example of this is the state of New Jersey's engagement of Merrill Lynch and UBS to advise on its options for extracting value from its transportation infrastructure.

Changing structures

But with the pace of development increasing, how such deals are structured is changing. One banker familiar with the market explains: "These deals are moving into the realm of leveraged financing – which has its own set of rules for doing business. As a result, the rules are being thrown in the bin for traditional infrastructure finance. If we look at debt-to-Ebitda ratios, we are clearly seeing more leverage than could traditionally be found for infrastructure finance."

Another infrastructure player agrees that this is having a significant impact on financing requirements for infrastructure projects. "I think the multiples are going up. It is definitely having impact and will test the bank market," he says. "Banks traditionally look at investment grade or crossover deals, but it is not a leveraged market. Those in the leveraged market do not currently play in the infrastructure market. So clearly we will need to see a change in this."

Banks are now looking at these assets in a different way, according to Spence. "These assets are longer term, with a lower risk profile than traditional project finance deals, and with quasi-monopolistic characteristics. They thus have a high degree of confidence in the credit quality of such deals and are therefore accepting more leverage than usual."

What they are getting for this is a better deal than in a normal project finance transaction, but they are providing terms that are competitive with traditional leveraged finance markets. Most market players have the sophistication to deal with this change, since many of those now involved in the US market are European lenders that have long invested in infrastructure, and understand these structures and the underlying credit.

They have the market knowledge to be comfortable with higher leverage, as one lender explains. "As a result of this aggressiveness, it is expanding the opportunities for project financiers," he says.

Supply and demand

While a number of concessions, a mixture of newbuild, brownfield and acquisitions or restructurings, are coming to market, it will be some time before deal structuring will catch up with investor demand. Rodriguez at Dresdner agrees that there is more demand for assets than supply at the moment, "simply because many states are still in the midst of getting things together to privatize these assets", he says. "But there is a pipeline out there, especially with PPP, and we expect a number of deals to come to market in the next couple of years. Our focus will be specifically on the acquisition of existing assets rather than greenfield developments."

Competition is also expected to have a big impact on pricing, as more players vie for those deals that are ready to launch. Spence says: "In terms of the impact on pricing, it will vary from deal to deal, but I would say that on average we will see prices averaging 100bp both up front and over 100bp for margins. This will mean better terms for airports and perhaps higher pricing for other acquisitions, such as roads."

He adds: "We also expect that even when refinancing these transactions, banks may have a more significant role than capital markets. Banks will dominate this space. In terms of deals themselves, some deals may have mezzanine involved."

Many banks are now bulking up their US infrastructure and project finance teams, after a prolonged freeze in hiring that followed the collapse of the US merchant power market. Bankers with experience of the European or Australian PPP market can command a hefty premium in New York.

Says one market participant: "They are taking a look at how to best target this growing segment. Some feel they need to get their name on the board, so they are bidding aggressively for deals that come up. It makes the landscape a bit more treacherous. In addition, many sponsors are asking for exclusivity, but we will see whether that flies."

How much and how long?

A number of states that traditionally have depended on the municipal finance market are now setting up programs to take advantage of the availability of equity funding and privatize assets. Rodriguez notes: "Texas and Florida both have big programs under way. Miami, for example, is seeking bids to build a tunnel. California has passed legislation pushing infrastructure deals, the New Jersey turnpike is being looked at, and Midway Airport may be privatized."

The $3.8 billion Indiana Toll Road transaction came to fruition in January, with Cintra and MIG winning the 75-year concession. In Colorado the Northwest Parkway – an 18km road running between I-25 and US-36 north of Denver – is at the shortlist stage, with 11 firms on the shortlist. And Morgan Stanley recently won the mandate for the Chicago Parking project, beating out a shortlist including heavyweights Babcock & Brown and the Carlyle Group, among others (for more on all these deals, please search for them by name at www.projectfinancemagazine.com).

As for the pipeline, market participants expect much activity in toll roads and utilities. One market participant also cites more activity in airports and ports. "In addition, we expect to see offshoots into other spaces such as arenas and hospitals," he says. "States own a lot of assets and will have to monetize them in some form."

Ultimately the prices that these fetch, and the degree to which banks can aggressively leverage them, depends on the length of the concessions on offer, and the degree to which states insist on buyers sharing excess profits. For the most long-term and least restricted assets, multiples are likely to be high, and banks will need to extend themselves to match.

Take the Indiana Toll Road financing, a $4 billion bank deal for Cintra and Macquarie's purchase of a 75-year concession on the 175-mile toll road. Lead arrangers, BBVA, BNP Paribas, Caja Madrid, DEPFA, Dexia Credit Local, Royal Bank of Scotland and Banco Santander, included a series of accreting swaps in the financing that deferred interest payments and allowed the buyers to raise higher levels of debt, and thus offer a higher price.

At least one banker, asked whether the resulting structure was maybe a little aggressive for buyers without strong banking relationships, begged to differ. "These concessions are really for very long periods. There's no reason why banks shouldn't accept the refinancing risk attached to these concessions, given they often have a decades-long tail."

If the statement is in any way representative, lenders should be prepared for a leveraged blowout.